A rate cut unlikely to give the US a lifeline

Desperate to aid an economy in crisis, the Federal Reserve is ready to deliver yet another big interest rate cut.

How big? One-half of a percentage point, some economists say. Investors and others hope for even more, a three-quarters cut or perhaps a full point, given the turmoil on Wall Street. It will be a close call, Fed watchers say.

The speculation will end on Tuesday afternoon after Fed Chairman Ben Bernanke and central bank policymakers have met.

Whatever the decision, for a growing number of analysts, one more rate reduction will not be the lifeline that pulls the country back from the brink of the first recession since 2001.

Experts in this camp believe the economy is shrinking now because of the fallout from the housing and credit debacles. Businesses are shedding jobs, Wall Street is convulsing, energy prices are skyrocketing and people are reluctant to spend. Yet these economists say lower interest rates should help cushion the blows of a recession. “Many consumers, businesses and investors are simply running scared right now,” economic consultant Carl Tannenbaum said.

The rate-cutting began in September with the goal of shoring up the economy and reviving spending. The Fed’s key rate has fallen from 5.25 per cent to three per cent. The pace picked up measurably in January when, during an eight-day period, the Fed slashed the rate by 1.25 percentage points. It was the biggest one-month reduction in a quarter century.

In response, commercial banks have lowered prime lending rates by corresponding amounts. The prime rate, now at a nearly three-year low of six per cent, applies to certain credit cards, home equity lines of credit and other loans. A cut on Tuesday would further drop the prime rate. Even with the Fed’s aggressive moves, economic and financial conditions keep deteriorating.

The Fed in recent days has taken extraordinary steps to help banks and Wall Street investment firms survive the stress of the credit crisis. Financial institutions have racked up multi-billion-dollar losses when mortgage-backed investments soured with the collapse of the housing market.

On Friday, the Fed used a Depression-era procedure to aid troubled Bear Stearns. The investment bank, which faced a possible collapse, received a rescue package from the Fed and JPMorgan Chase. Bear Stearns, which had made a fortune in mortgage-backed securities, has taken $2.75 billion (Dh10bn) in write-downs since last year.

Consultations about the situation continued through the weekend among representatives from the Fed, Treasury Department, financial institutions and others. President George W Bush will meet his advisory panel on financial markets on Monday, whose members include Bernanke and Treasury Secretary Henry Paulson. The panel on Thursday recommended stricter regulation of mortgage lenders as part of a broad effort to prevent a repeat of a credit crisis threatening to drive the country into recession.

The Fed the past week also said it would pour as much as $200bn into big Wall Street banks and investment houses and allow them to put up risky home-loan packages as collateral. This manoeuvre was intended to bring sorely needed relief in the market for mortgage securities. The Fed also has offered as much as $200bn in short-term loans to banks and large financial institutions.

Some economists believe these actions minimise the need for an interest rate cut of 0.75 per cent, or more, on Tuesday. “I saw it as a bit of a substitute for the super-size rate cut that the financial markets are expecting,” said Stuart Hoffman, chief economist at PNC Financial Services Group. Hoffman is predicting a half-point cut.

The Fed’s rate cuts have added to the downward pressure on the value of the dollar, which recently plunged to a record low against the euro and has fallen sharply against the Japanese yen. The dropping dollar is stoking fears that inflation might take off. The weaker dollar could raise the cost of imported goods entering the US and lead American companies to raise prices as foreign-made products become more expensive.

To Hoffman, that is a case for going with the half-point rate reduction. Other analysts believe the situation is so dire that the Fed must cut deeper. Brian Bethune and Nigel Gault, economists at Global Insight, are among those predicting a three-quarter point reduction. Given the turmoil on Wall Street, there is even a chance of a one percentage point cut, they said.

Dangerous cracks, meanwhile, are deepening in the job market. Employers did away with 63,000 jobs in February, the most in five years. It was the second month in a row in which nervous employers got rid of jobs. With the economy faltering, economists predicted the unemployment rate – now at 4.8 per cent – would climb to 5.5 per cent by year’s end. Even after Tuesday’s expected rate cut, economists predict the Fed’s key rate will head even lower, probably to two per cent or even lower by the spring or early summer.

The rate reductions and the government’s economic aid plan of tax rebates and breaks should help economic growth in the second half of this year, analysts said.

“If we can make it through the first part of this year and then recover, that would be a remarkable achievement,” Tannenbaum said. (AP)